Erstwhile mechanical engineer and Forbes Executive Editor, with MBA from NYU. In 15 years at Forbes I covered large corporations, money managers and self-made wealth builders---and the myriad trials they all face. Joined the tech-startup ranks in 2014 as co-founder and CFO of Eyes/Only, a luxury-experience portal for high-net-worth individuals. If the mood strikes (and especially if you have a tasty-tequila rec), please send your thoughts to brett@eyeson.ly.

The Truth About What Facebook Is Really Worth

When the fiasco over FacebookFacebook’s bungled public offering finally subsides, one very hard question will remain: What are the shares of this company actually worth?

Given how experienced stock pickers go about their art, the gyrations over the last few days are virtually beside the point. Here’s why:

The last time you bought stock in a company, you probably had a reasonable argument for why you thought its price would rise: the company makes dependable products that people need, it has competent leaders at its helm, the shares look cheap relative to those of inferior rivals, etc. You also might even know (in theory) how sophisticated participants in the market attempt to arrive at a fair value for those shares.

A quick refresher on that last part, just in case: The price of a share of stock is based on how much money a company can potentially earn in the future. Makes sense: Ultimately, companies are only worth something if they can generate positive cash flows; otherwise, the owners should just fire the staff, sell the buildings, furniture and equipment, and move on.

Once you’ve estimated those cash flows, you must convert them to present dollars by dividing them at some appropriate rate equal to the return you might have earned investing your money in a similarly risky venture. That’s it: Estimate the cash streams and discount them to present dollars.

Doing a traditional “discounted cash flow” (DCF) valuation calculation isn’t rocket science, but doing it right requires a fair bit of work and a ton of educated guessing. (There are less rigorous valuation techniques, like price-to-earnings ratios and the like, but DCF is the king.)

Let’s focus on the guessing part of this game, and what it means—or doesn’t—for a company like Facebook.

A valuation model basically comes in two pieces: the earnings to come in the next five years (which you can approximate with some confidence) and the earnings to come all the years after that (which you estimate by waving what amounts to a wet finger in the air). That second piece is called the “terminal value.” Sum up those two pieces, divide by the number of shares, and Voila: you have the total present value of the stock today.

The first piece is hard enough to get a handle on, depending on what industry a company is in. If the company manufactures sheet steel, estimating earnings for each of the next five years is relatively easy—assuming the global economy doesn’t implode or the world doesn’t discover a stronger, cheaper substitute for steel between now and 2017.

If, however, the company makes, say, designer jeans or smart phones, the estimates get a little fuzzier, given how finicky consumers can be. If the company sells online advertising on a social networking platform, well, who knows what that market will look like in the next five months, let alone in the next five years?

Here’s the really unsettling part: The first piece of the valuation model (comprised of the cash flows over the next five years) might only account for a quarter of the overall valuation. The second piece (the terminal value) accounts for the rest, along with the value of any real estate, marketable securities and cash. In other words: Most of the stock price is tied up in the terminal value.

How hard is it to calculate the correct terminal value? Really hard. I won’t derive the formula, but here it is:

TV = cash flow in Year 6 / (r – g)

In the formula, “r” equals the long-term discount rate, and “g” equals the company’s long-term growth rate (assumed to smooth and flatten over time).

While the arithmetic is easy, you can see how even small changes in that denominator would wildly swing the terminal value.

Facebook logo (Photo credit: Wikipedia)

Consider: In a May 7 research report, Brian Wieser, an equity analyst with Pivotal Research Group, kindly provided a matrix of potential valuations for Facebook based on different assumptions for both the long-term discount rate and the long-term growth rate. Just based on changes in the resulting terminal value, Facebook’s valuation would swing between $23 and $81, and the company’s total market value between $59 billion and $207 billion. That’s a big swing. In Wieser’s model, Facebook’s terminal value accounts for fully two-thirds of its overall worth. He thinks Facebook’s shares are fairly priced at $30.

“The change [in price] can be pretty substantial with a change in discount rate or growth rate,” says Wieser. “My philosophy on this: Establish a benchmark you’re comfortable with—in this case, GoogleGoogle—and assess the metrics on discount rate or growth rate by comparison.” He’s right: That’s about all you can do.

So what does all of this glorified guesswork mean for Facebook shareholders and those watching anxiously from the sidelines?

If you’re placing daily bets on Facebook shares (and I sincerely hope most of you aren’t), then obviously you care a lot if they lurch 15% in either direction. But as to whether the company is intrinsically worth $30 or $40 or anything in between, much of what’s in that number, by definition, is noise at the moment.

Social networking is no fad, and Facebook is a giant. It’s worth…something. As to how much, even talented analysts can’t know with precision. Eventually (though probably not for awhile), the company’s cash flows will coalesce around some better-defined trajectory, the valuation models will firm up and comfort levels will rise.

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Facebook is definitely a fad. Look at myspace, that was ruling social media until facebook went public and people flocked to it.. probably because myspace was insanely immature and pages looked horribly glittered with bad layouts from being way too open. Whats to say for some reason Google+ takes off and starts overtaking facebook users and then facebook just dies out? I’m no fan of much anything google but its a probably outlook and could happen or some other social media could come out. Instagram was taking off tremendously taking away the heat from facebook until they bought them… No chance for facebook to buy up google… never know.. but this is definitely a fad and most likely will be replaced. The young generation is all about whats hip, whats cool, and they want it now… if something better than facebook comes along.. people will flock to it, and they will do it quickly

Social Networking as a facility is huge and here to stay. Facebook is a shambles and Facebook’s future unless it sorts out its hacking and moderation problems is share price collapse and a sell off to a consortium in the Middle East Arab business Community.

All reasons to recognize that putting a price on Facebook, at this point, is a very tricky proposition. The important thing is to understand what you’re getting into before you plunk down any mad money. Thanks for reading.

MySpace has been as dead as disco for the last four years, it’s fall out of favour may have had plenty to do with facebook but absolutely zero to do with facebooks IPO.

I believe that in 5 to 10 years time, facebook will either be a relic of the past or even more deeply ingrained in the day to day interactions of humans. To say facebook is a fad is pure nonsense. A fad that’s been growing for 8 years?

As for this young generation you say are looking for “what’s hip” (which blows your credibility out of the water completely, by the way) yes, they do indeed flock to the next great thing that engages them but the big players won’t lie down quietly and they’ve got some very shrewd people working over there.

Don’t be goose on the internet. Let’s call a spade a spade here. Facebook is no fad.

” I can’t help but wonder, if Facebook came out at 20 or 30 percent less, wouldn’t we be talking about this as an incredibly successful IPO? ” Ty Kiisel

Facebook will probably go down through the thirty dollar barrier on Thursday unless it receives massive and aggressive price support from the underwriters and if Facebook will not or can not fix its hacking and moderation problem, I do not believe a share price of ten dollars is sustainable. If Facebook continues on its present track, I believe that its worth as a commercial forprofit company is around eight hundred million dollars and a share price of circa thirty eight cents.

Facebook is very seriously hacked at a systems level by a professional organization which is either a hostile to the USA intelligence service or a major criminal organization. The hackers are Islamonazis / Islamofascists or FTs. The Facepook Fanpages are massively compromised by the hacking activity and for example many or all of the official US State Dept Facebook Fampages are substantially controlled by the hackers including the the US London, Tel Aviv and Kabul Embassy Fanpages. Furthermore, the hackers can interfere with how personal accounts interface with Facebook systems software. On top of that, Facebook moderation pander to and featherbed the likes of neo-Nazis whilst putting posting bans and even permabanning the Facebook accounts of the likes of Ronald Reagan and Senator Barry Goldwater Conservatives over trivial issies or even for doing nothing wrong. Facebook is a rabidly antisemitic organization and the proactively supports the mass murder of the Jewish populations of Israel, the British Isles and Continental Europe in Concentration Camps with Zyklon B. Facebook is a can of worms and all sorts of things may come in to the light of day if as result of Facebook’s share price problems serious investigative journalists start to look at Facebook, for example, how is it that the US has a massive and very expensive intelligence capability and yet the hackers have been able to substantially control oUS Government and US Government Agency official Facebook Fanpages for months on end without the US Government and the US Government Agencies apparently being aware that anything is wrong with their Facebook pages.